Last week’s rollout of two exchange-traded funds invested in closed-end funds brought attention to a somewhat arcane corner of the investing world that offers investors something they crave in the current low-interest-rate environment—namely, big fat yields in the form of high distribution rates.
As a refresher, closed-end funds are investment companies registered with the Securities and Exchange Commission that pool together money from investors to buy securities and manage them in a portfolio. These funds issue a fixed number of shares through an initial public offering, and a fund’s share price fluctuates based on supply and demand in the open market. Typically, most closed-end funds trade at a discount to their net asset value.
That sounds like a negative, but it’s actually a selling point because buying a closed-end fund at a discount allows for capital appreciation if the discount narrows.
And because these are “closed” vehicles with relatively stable capital, they have more flexibility to invest in less-liquid assets that potentially offer high returns. Furthermore, the closed structure means they don’t have a cash drag that comes from holding excess money to cover shareholder redemptions, as is the case with open-end mutual funds. As such, they can be fully invested.
“Closed-end funds provide the potential to make money three different ways,” said Neil Azous, founder and chief investment officer at Rareview Capital LLC, a Stamford, Conn.-based registered investment advisor that last week launched two ETFs invested primarily in fixed-income closed-end funds.
One way to make money is through a fund’s distribution yield, which is paid monthly or quarterly. Distributions can include interest income, dividends, capital gains or a combination thereof. “The average yield in the entire universe of closed-end funds is around 8%, or slightly higher at the moment,” he said.
The second return stream can come from appreciation at the net asset value level when the underlying assets go up in value.
“The third way is that typically 80% or 90% of closed-end funds trade at a discount to their net asset value,” Azous explained. “If you understand where the fair valuation is, and the closed-end fund is at a wider discount, you can purchase that and sell it later as that discount narrows closer to its fair valuation. We term that as alpha.”
Rareview ETFs
Azous said the investment model underpinning his firm’s two actively managed products—the Rareview Dynamic Fixed Income ETF (RDFI) and Rareview Tax Advantaged Income ETF (RTAI)—employs a quantitative approach designed to exploit the dynamics of discounts.
The RDFI fund has 19 holdings, and it had a recent weighted average discount to NAV of minus 10.64%. The portfolio can include a range of fixed-income asset classes including U.S. government securities, investment-grade and high-yield credit, leveraged loans and emerging-market debt. When it launched on October 21, the fund’s largest allocations were to government securities (53%) and non-investment grade credit (36%).
According to fund literature, the average distribution yield in RDFI’s target universe of fixed-income closed-end fund holdings is 8%.
The RTAI fund invests in municipal bond closed-end funds. It has eight holdings and a recent weighted average discount to NAV of minus 12.65%. Nearly 90% of the portfolio consists of investment-grade securities.
Rareview Capital’s model-driven approach uses a screening process involving about 20 different steps ranging from analyzing the issuer and its balance sheet and financials to whether the portfolio manager has delivered on its goals and why a closed-end fund is trading at a particular discount.